Federal Reserve Approves Capital Restraints for Big Banks

Credit...Mike Segar/Reuters

Nearly eight years after panic on Wall Street tipped the country into a severe recession, federal regulators are still trying to minimize the risks to the overall economy posed by large banks.

The Federal Reserve introduced new restraints on Monday that would apply to eight of the nation’s largest banks, which hold more than $10 trillion in loans and securities. The banks include big Wall Street firms like Goldman Sachs, Citigroup and JPMorgan Chase, which currently faces an estimated $12.5 billion financial shortfall under the new rules.

The regulations stop short of requiring banks to shrink to a particular size, an approach that the Obama administration and Congress deliberately avoided in the Dodd-Frank Act, the signature financial overhaul passed five years ago.

Instead, in its new rules, the Fed is setting standards for the amount of capital a bank must have. The new requirements could persuade the firms to get smaller over time — making them more resistant to economic shocks and less likely to damage the economy should they fail.

“This final rule will confront these firms with a choice: They must either hold substantially more capital, reducing the likelihood that they will fail,” Janet L. Yellen, chairwoman of the Federal Reserve, said in a statement, “or else they must shrink their systemic footprint, reducing the harm that their failure would do to our financial system.”

As Ms. Yellen indicated, the Fed’s new rules, which were proposed in December, focus on a bank’s capital. Banks raise most of the money they use for lending or trading by taking in deposits or borrowing in the markets. But that source of money can dry up very quickly in a crisis and cause bank runs, as happened in 2008. As a result, regulators have required that banks get more of their funding from their shareholders, who cannot withdraw their money in a panic. This more stable source of funding, combined with a bank’s retained profits, is called capital.

The Fed’s new rules force the largest banks with the biggest Wall Street operations to meet the highest capital requirements. As well as making the big banks safer, the rules may also persuade them to get smaller. Capital is an economically expensive funding source for a bank. As regulators demand that large banks have more capital, their overall expenses rise. In turn, the banks may decide to pare down their less profitable businesses and shrink over time. Previous regulatory initiatives that increased capital already seem to have had that effect, and the Fed may want to see that continue.

The Fed’s five board members voted unanimously in favor of the new capital rules in an open meeting on Monday.

Under international banking rules that apply to American institutions, the eight banks have to have a capital base that is equivalent to 7 percent of their assets, which are made up of loans, securities and cash. The international rules then envisioned a layer of additional capital for the largest firms. Officials at the Fed, however, wanted the extra amounts, which they are calling surcharges, to be still larger for American banks. The officials also favored larger capital requirements for big Wall Street banks that borrow large sums of money in markets that are prone to panic.

“A set of graduated capital surcharges for the nation’s most systemically important financial institutions will be an especially important part of the strengthened regulatory framework we have constructed since the financial crisis,” Daniel K. Tarullo, the Fed governor who oversees regulation, said in a statement.

He was behind the push to make the extra capital requirements tougher and to make them more stringent for banks that borrow heavily in short-term debt markets. Such borrowing dried up rapidly in 2008, spreading fear through the financial system and forcing the Fed to extend emergency loans to Wall Street.

JPMorgan Chase, the nation’s largest bank by assets, would have to hold the most in extra capital. Its additional amount would be equivalent to an estimated 4.5 percent of its assets, if the calculation were done on the bank’s recent numbers. The bank would need to increase capital by an estimated $12.5 billion to comply with the 4.5 percent requirement, according to a Fed official, down from an estimated $20 billion last year when the rule was proposed. Financial actions by JPMorgan Chase — like cutting assets or holding more capital — and not a loosening of the final rule explain the reduction, a Fed official said.

The other seven banks already have enough capital to meet the requirements of the new rule. Citigroup’s estimated surcharge of 3.5 percent is the second-largest in the group. Morgan Stanley and Goldman Sachs would need an estimated 3 percent in additional capital. Wells Fargo, a large bank that has little presence on Wall Street, would face only a 2 percent requirement, under these estimates. The rule doesn’t fully take effect until the start of 2019.

The Fed refrained on Monday from taking a step that the largest banks feared. The Fed decided against incorporating the extra capital requirements in its annual “stress tests” of the banks’ health. That could have forced many of the banks to raise even more capital. Still, Mr. Tarullo held out the possibility that the Fed may later discuss including the extra capital requirements in the stress tests.

Representatives for the large banks had criticized the new rules, contending that they might make American banks less competitive compared with foreign banks. But the standing and profits of American banks have remained strong as they bolstered their capital in recent years.